Accounting for managers

1
Accounting for managers

• An introduction to financial accounting
• doc. dr. Aljoa Valentincic

2
Liabilities

• A liability
• Present obligation of the firm to another party
• Arises from past transaction or event
• Involves sacrifice of assets of known or
  estimated amount
• When to recognise a liability?
• it is probable resources will flow out of the
  company
• the outflow can be reliably estimated
• Liabilities are recorded when obligations occur
• by transactions (goods are bought on credit)
• by passage of time (interest payable an
  accrual)
• very often, failure to recognise a current
  liability is related to failure in recognising an
  expense
• understatement of expense, overstatement of profit

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Contingent liabilities

• A contingent liability possible liability
• A potential liability depending on a future event
  based on a past transaction or event
• Probable reasonably estimated
• If only one ? disclosure in notes to financial
  statement
• e.g., Walt Disney, AR 2006, pgs. 61, 96-97The
  Company also has certain contractual arrangements
  that would require the Company to make payments
  or provide funding if certain circumstances occur
  (Contingent Commitments). The Company does not
  currently expect that these Contingent
  Commitments will result in any amounts being paid
  by the Company.
• Provision
• an estimated liability (the amount or timing is
  uncertain)
• e.g., product warranties, airline miles
• an accrued cost (the amount or timing is
  uncertain)
• e.g., maintenance repair, very typically in
  gas/heating
• Big-bath provisions (restructuring provisions)
• bring forward normal future costs

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Long-term debt (bonds)

• A bond is a security representing money borrowed
  from the public by a company or government
• An investor ( buyer of the bond) lends the money
  in exchange for a promise ( bond) from the
  company that she will receive regular interest
  plus principal in the future
• At primary transaction
• Sold and quoted on secondary markets
• at face value, also nominal or par value (100)
• at premium (e.g., 103 ½ of face value)
• at a discount (e.g., 87.62 of face value)

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E.g., Walt Disneys Sleeping beauty bonds

• Price 7.55 senior debenture, due 2093
• Price to investors 100 (of face value),
  received by WD per bond 98.875, issuance costs
  1.125
• Interest payments 2 times a year, January 15th,
  July 15th
• Disneys option to call or redeem the bonds
  beginning July 15, 2023 at 103.02 of their face
  value declining to 100 of face value after
  July 15, 2043

www.wikipedia.org
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UK gilts (government bonds)
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Bond issue

• Issuance at face value face value is 100,000,
  coupon 9, maturity 5 years, coupon payment
  dates on January 1st and July 1st, simple
  interest method.
• Entry of Issuance
• Dr. Cash 100,000
• Cr. Bonds payable 100,000
• ( a L-T liability)
• Very very rarely (if ever see Walt Disney
  Sleeping Beauty issue), so

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Coupon and effective interest (yield)

• If market interest rate is higher than the coupon
  interest rate bonds are sold at a discount
• market gt coupon
• i.e. the market requires a higher interes rate
  than the bond is bringing in in the form of
  coupons
• If market interest rate is lower than the face
  interest rate bonds are sold at a premium
• market lt coupon
• i.e. the market is too happy with the yield
• Face interest rate interest rate paid to
  bondholders based on the face value of the bonds
  (coupon)
• Market interest rate i.r. paid on the market
  for bonds of similar risk (and maturity)

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Illustration

• Take the Sleeping beauty bonds, assume no
  issuance costs What if they were issued to
  investors at the following prices
• 75.5401 of face value (of, say 100)
• coupon interest rate 7.55 per year or 3.775 per
  period, market interest rate 10 per year or 5
  per period!
• what if price was 187.0590

IRRYTMmarket i.r.5
IRRYTMmarket i.r.2
10
Bonds issued at a discount

• Issuance of bonds 100 000, at 96.139, coupon
  9, effective market rate 10, maturity 5 years,
  interest payment dates at January 1st and July
  1st.
• Entry
• Dr. Cash (A) 96 139
• Unamortized bond discount (CL) 3 861
• Cr. Bonds payable (L)
  100 000
• Unamortized bond discount a contra-liability
  account
• Has a normal debit balance
• Logic just the opposite of a contra-asset
  account, but serves same purpose

11
Bonds issued at a premium

• Issuance of bonds 100,000 at 108,317, coupon
  9, effective market rate 7, maturity 5 years,
  interest payment dates at January 1st and July
  1st.
• Entries
• Dr. Cash (A) 108,317
• Cr. Bonds payable (L) 100,000
• Unamortised bond premium (CL-) 8,317
• Again, a contra account

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What is a discount?

• The discount represents an additional cost over
  the cost reflected in the coupon interest rate
• This cost relates to all periods for which the
  bond is outstanding
• To account for this additional cost
• Calculate total (or lifetime) cost of debt
• Spread it out over the entire period for which
  the bonds are outstanding
• spread out over 5 years (10 half-yearly periods)
• 4,886 per period (a difference of
  4,886-4,500386/p.)

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Recognising this in financial statements

• Recognition of bond interest payable
• Dr. Bond interest expense (OE-) 4 886
• Cr. Unamortized bond discount (CL-) 386
• bond interest payable (L) 4 500
• Payment of Interest
• Dr. Bond interest payable (L-) 4 500
• Cr. Cash (A-) 4 500
• Remember The Unamortized bond discount
  normally has a debit balance
• To decrease it, we must credit it

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A problem

• Because a balance-sheet account is changing, so
  is the carrying value of the bonds
• It looks like the cost of debt is changing, if
  you look at the financial statements!
• Economically, the cost is 10 per year (or 5 for
  half a year)
• i.e., the cost for the firm is locked-in at the
  moment of issue
• thats why companies issue very long bods in
  periods when interest rates are very low (e.g.,
  Coca-Cola and Walt Disney Co. 100-year bonds)
• Solve the problem using an alternative method

15
Interest method of amortisation of a bond discount

• Three steps
• find the yield to maturity (YTM) at issue
• this is the effective interest rate at which the
  company can borrow at the moment it issues debt
• use (YTM opening book value of debt) ? gives
  interest expense (in ) for the period
• interest expense interest paid ? amortisation
  of bond discount (a residual)
• Adjust the carrying amount by adjusting the
  discount (Unamortized bond discount)

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Interest method
98,22754,911

• This time the percentage cost of debt is not
  changing
• reflecting the economic reality a lock-in of
  5 per half year

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Recognising this in financial statements

• For example, in period 7
• Recognition of bond interest payable
• Dr. Bond interest expense (OE-) 4,911
• Cr. Unamortized bond discount (CL-) 411
• Bond interest payable (L) 4 500
• Payment of Interest
• Dr. Bond interest payable (L-) 4 500
• Cr. Cash (A-) 4 500

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Derecognition the normal way

• At maturity of bonds, the final economic act is
  to pay back the principal
• Dr. Bonds payable (L-) 100,000
• Cr. Cash (A-) 100,000

19
Derecognition early retirement

• If market interest rates rise (fall) since issue,
  fair value will be less (higher) than book value
• The borrower (issuer of bonds) will record a
  gain (loss) for the difference
• Say the company decides to retire bonds at end of
  period 7 and interest rates have increased to 12
  (6 per half year)
• The market value of the bond is 95,990
• The book value of the bond is 98,638 at end of
  period 7
• see a few slides back
• this is the Bonds payable Unamortised bond
  discount together
• A gain of 98,638 - 95,990 2,648
• the firm has to pay on the market only 95,990
  that its books say is worth 98,638
• and this is given the situation at issue

PV of all future CFs at t7 at 6 per period!!!
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Recognising this in financial statements

• Dr. Bonds payable (L-) 100,000
• Unamortized bond discount (CL-) 1,362
• Cr. Cash (A-) 95,990
• Gain on early retirement of bonds (OE)
  2,648

Book value of bond at t7 (98,638)
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Derecognition loss on early recall

• Say the company decides to retire bonds at end of
  period 7 and interest rates have decreased to 8
  (4 per half year)
• The market value of the bond is 100,690
• The book value of the bond is 98,638 at end of
  period 7
• see a few slides back
• this is the Bonds payable Unamortised bond
  discount together
• A loss of 98,638 - 101,388 2,749
• the firm has to pay 101,388 for something its
  books say is worth only 98,638